infonet-economy

This paper studies the term structure implications of a simple structural economy in which the representative agent displays ambiguity aversion, modeled by Multiple Priors Recursive Utility. Bond excess returns reflect a premium for ambiguity, which is observationally distinct from the risk premium of affine yield curve models. The ambiguity premium can be large even in the simplest logutility model and is non zero also for stochastic factors that have a zero risk premium. A calibrated low-dimensional two-factor economy with ambiguity is able to reproduce the deviations from the expectations hypothesis documented in the literature, without modifying in a substantial way the nonlinear mean reversion dynamics of the short interest rate. In this economy, we do not find any apparent tradeoffs between fitting the first and second moments of the yield curve and the large equity premium.